Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.

Kyiv, March 31, 2008

The Ukrainian economy has grown strongly since 2000, supported by a robust international environment, stabilizing macroeconomic policies, including the de facto currency peg to the dollar and low fiscal deficits, as well as significant structural reforms. By many measures, Ukraine has also become better insulated against shocks. Reserves have increased substantially and now cover 170 percent of short-term debt or four months of imports. The underlying fiscal position is strong: government debt is only about 10 percent of GDP, and the deficit, if maintained at the present level, would ensure fiscal sustainability under a wide range of scenarios. The financial sector as a whole appears to be well capitalized and profitable, and has been strengthened by the increasing importance of foreign banks. WTO accession and the negotiations for an EU trade agreement should spur structural reform efforts.

However, over the last three years expansionary fiscal and incomes policies, rising terms of trade, surging capital inflows, and a credit boom and have led to very strong domestic demand growth and a deteriorating current account position. Surging demand, along with rising food and gas prices, has raised inflation to unacceptably high levels. Moreover, inflation may be increasingly entrenched in expectations and wage setting, partly reflecting the legal mechanisms determining the official subsistence level and minimum wage.

Amidst turmoil in global financial markets and volatility in world commodity prices, the Ukrainian economy also faces significant external and financial vulnerabilities:

• On the external side, the real exchange rate is still broadly consistent with fundamentals, but overvaluation could result if inflation persists and the current account deficit continues to widen. Also, the terms of trade may deteriorate as Ukrainian gas prices move to world levels and because steel prices might soften as world economic growth slows.

• On the financial side, global turbulence has heightened external financing risks, including for rising short-term debt rollover, as interest rate spreads have widened (more than in many other emerging markets) and euro-bond issues have dried up. Very high domestic lending growth, including in foreign exchange to unhedged borrowers, points to increased credit risks, and a number of smaller banks seem to be weak. The potential reversal of high asset valuations, notably in some urban real estate markets, poses further risks.

Against this backdrop, the mission expects growth to slow modestly toward a more sustainable rate in 2008, and further in 2009, as weaker world growth reduces export demand, terms-of-trade gains moderate, and ongoing difficulties in international financial markets tighten financing conditions and reduce the pace of credit expansion. Still high domestic demand growth and rising gas prices will contribute to a further widening of the current account deficit, financed by continued inward direct investment. However, as the economy slows and food prices begin to stabilize, inflation should fall gradually, reaching 17 percent (December on December) by the end of 2008.

We would emphasize the large uncertainties of this projection. For example, a fiscal expansion or greater steel price increases would raise growth, but also inflation. Intensified global financial market turbulence that spilled over into Ukraine could cut growth substantially. Given still buoyant steel prices and domestic credit expansion, we assess the risks in 2008 as somewhat on the upside for both inflation and growth.

Policy recommendations

The mission strongly supports fundamental structural reforms, which will be essential to ensure higher output and living standards over the medium term. However, these reforms will take time to raise aggregate supply. Therefore, high inflation, rising vulnerabilities, and global financial turbulence call for near-term measures to strengthen fiscal, monetary, and financial policies. In this connection, the mission welcomes calls in the authorities' recent anti-inflation program for greater fiscal prudence and better use of the exchange rate band. Our policy recommendations focus on current macroeconomic policy needs and, if implemented, would contribute to stabilizing the external position and reducing inflation, which could fall to single digits by end-2009.

Fiscal policy

For this year, the burden of controlling demand and inflation must fall on fiscal policy, because limits to exchange rate flexibility preclude sufficiently effective monetary policy action. A general government deficit reduction of 1½ percent of GDP in 2008, bringing it to near balance, would ease pressures significantly. Holding nominal spending to the level specified in the December budget and saving all revenue overruns, including in social funds, would largely achieve this deficit objective; excess privatization receipts should also be saved. Further cuts, if needed, should be implemented by restraining subsidies and social transfers, because these feed directly into demand and inflationary pressure.

Other fiscal measures will be needed to ensure a sustained reduction in inflationary pressure. Minimum wage, public sector wage, and social spending growth should be held to rates consistent with single-digit inflation; the current increases of 20-40 percent feed inflationary pressures and undermine anti-inflationary policies. Restitution of lost savings should be spread over a number of years or offset by spending cuts elsewhere. Tax cuts, which are desirable as part of an overall reduction in the size of government, should be fully offset with spending cuts or base broadening (for instance, via improved tax administration, especially of the VAT; by contrast, abolishing the VAT would risk increasing evasion and move Ukraine away from European norms).

Given the large uncertainties regarding the prospects for output growth and inflation, the authorities should stand ready to adjust the fiscal stance as needed. If growth does not slow as we anticipate, inflation pressures would be stronger and a still tighter fiscal stance would be needed. Conversely, the sustainable medium-term fiscal position provides room to ease the fiscal stance if downside risks materialize and inflation clearly abates.

The fiscal framework also needs strengthening. Further improving macro-fiscal analysis would clarify the macroeconomic impact of fiscal policy, and integrating it into the budget process would help to prevent the procyclical stance that has characterized fiscal policy in recent years. A multi-year fiscal framework, including spending ceilings, would facilitate monetary-fiscal coordination and help to guide budgets toward medium-term fiscal goals (for example, gradually reducing the size of government, or implementing pension reform). Broader fiscal coverage and closer monitoring of public enterprises would identify and contain fiscal risks. Reducing the use of administered prices would improve the fiscal position and economic efficiency. In particular, gas price increases should be passed through fully to final users, with vulnerable groups protected by better targeted social programs.

Monetary policy

The mission welcomes recent NBU policies to tighten monetary conditions, including by stepping up sterilization and broadening reserve requirements. Until inflationary pressures ease, the NBU should continue such efforts to the extent feasible. As this will be costly, the government should accept profit transfers from the NBU that deviate from budget targets. However, at some point short-term capital inflows and strains on financial institutions will limit the scope for further tightening in the current policy framework.

The de facto exchange rate peg is no longer adequate to contain inflation, encourages dollarization, and prevents the nominal exchange rate from cushioning activity against external shocks. Therefore, as anticipated in the 2008 monetary guidelines, the current monetary framework should be replaced by, first, a more flexible exchange rate and, ultimately, by inflation targeting. This transition, which we recommend begin now, will require a joint and coordinated effort between the government and the NBU:

• Public and decisive government support for the proposed new monetary policy regime is fundamental, since otherwise it will lack crucial political credibility. A key part of this support is legislative and de facto guarantees of central-bank independence to carry out monetary policy operations. In preparation for inflation targeting and to develop key asset markets for monetary policy operation the government should abolish the tax on foreign exchange transactions, convert its outstanding liabilities to the NBU into tradable securities by mid-year, and issue more public debt in hryvnia. Also, the extensive use of administered pricing should be scaled back to provide monetary policy maximum leverage over inflation.

• The NBU, with government support, should as a first step establish and fully use an exchange rate band that allows more scope for active monetary policy. The 2009 monetary policy guidelines should indicate that the band will be progressively widened as circumstances permit and policy needs require, without specifying bands or timing in advance. The NBU should continue its welcome efforts to strengthen its analytical capacity and integrate macroeconomic analysis into its policy decisions. Communication with the public and the markets needs to be improved, including through publication of inflation reports and regular, transparent announcements of policy intentions and actions.

Financial-sector policy

In view of actual and possible strains, we urge the NBU to continue to intensify its supervision of banks. Key measures are consolidated supervision, increased transparency of bank ownership (the recent publication by the NBU of bank ownership is welcome in this regard), encouragement to banks to enhance their risk management capabilities, strong guidance regarding stress testing, and intensified on-site examinations. Bank secrecy provisions should be brought into line with Basel II standards. Prudential measures might include, in addition to the recent welcome increase in minimum statutory capital, greater risk weights for assets that pose higher credit risk (notably unhedged foreign currency denominated lending) and stronger prudential requirements for banks with deteriorating liquidity positions. Finally, nonbank supervisors should be strengthened, which would also foster the development of insurance and capital markets.

The mission supports the authorities' intention to implement a sequenced liberalization of capital controls, including through a new foreign exchange law. Safeguards should be retained, but used only in clearly specified and exceptional circumstances.

The mission recommends greater attention be paid to bank resolution and crisis management. On the former, problem banks need to be identified earlier and bank exit options expanded to include rapid resolution mechanisms, notably by increasing incentives of owners of weak banks to agree to mergers. On the latter, contingency planning should be further developed and refined, to ensure an effective response in the event of unforeseen turbulence.